The Risk of Economic Crisis

Martin Feldstein, Martin Feldstein

• Publisher: University of Chicago Press
• Year: 2009
• ISBN:
  9780226241838
• Topic: Commerce
• Subtopic: Commerce Général

The stunning collapse of the thrift industry, the major stock slump of 1987, rising corporate debt, wild fluctuations of currency exchange rates, and a rash of defaults on developing country debts have revived fading memories of the Great Depression and fueled fears of an impending economic crisis. Under what conditions are financial markets vulnerable to disruption and what economic consequences ensue when these markets break down?In this accessible and thought-provoking volume, Benjamin M. Friedman investigates the origins of financial crisis in domestic capital markets, Paul Krugman examines the international origins and transmission of financial and economic crises, and Lawrence H. Summers explores the transition from financial crisis to economic collapse. In the introductory essay, Martin Feldstein reviews the major financial problems of the 1980s and discusses lessons to be learned from this experience. The book also contains provocative observations by senior academics and others who have played leading roles in business and government.

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The Risks of Financial Crises

1. Benjamin M. Friedman

2. E. Gerald Corrigan

3. Irvine H. Sprague

4. Norman Strunk

5. Joseph A. Grundfest

1. Benjamin M. Friedman*

Views on the Likelihood of Financial Crisis

Financial crises have traditionally attracted a peculiar fascination. It is difficult to specify with precision just what a financial crisis is, but most people in the business and financial world apparently sense that they would recognize one if they experienced it. More important, the fear of financial crisis is often a key motivation underlying actions in both the private and public policy spheres.

Concern about the likelihood of a financial crisis in the United States has become more widespread in recent years for several reasons. First, the wave of restructurings and reorganizations that has affected much of U.S. corporate business in the 1980s has, in one way or another, typically involved the substitution of debt for equity capitalization. As a result, the corporate sector’s interest burden has risen sharply compared to its earnings, thereby prompting questions about the ability of more heavily indebted firms to meet their obligations in the event of a general slowdown in nonfinancial economic activity. This substitution of debt for equity has not merely involved a few individual transactions large enough to attract attention under any circumstances—$25 billion for RJR Nabisco, for example—but has also reached a scale that is hard to ignore at the aggregate level. During the six years between 1984 and 1989, the volume of equity that U.S. firms in nonfinancial lines of business retired, through various restructuring transactions, exceeded the gross proceeds of nonfinancial firms’ new equity issues by $575 billion.

Second, the actual record of failures of both nonfinancial firms and financial intermediaries has been extraordinary in the 1980s. The business expansion following the severe 1981–82 recession was the first on record in which the failure rate among nonfinancial businesses continued to rise long after the recession ended, rather than dropping back to pre-recession levels. Moreover, on inspection it is clear that this phenomenon has not been merely the natural counterpart of an unusually large number of new business start-ups. (Contrary to popular impressions, the 1980s has not been an unusually fertile period for new business formation activity in the United States.) Within the financial intermediary system, both the actual failure experience and the perceived threat of further failures have been unprecedented since the 1930s. More than 1,000 commercial banks failed during 1981–89—including 206 in 1989 alone—versus only 79 during the 1970s and just 91 from the end of World War II through 1970. Hundreds of savings and loan institutions became insolvent in the 1980s, yet continued to operate anyway because the FSLIC (unlike the FDIC) lacked the resources to close them; in 1989 Congress voted a bailout plan for the thrift industry that will cost far in excess of $100 billion.

Yet a third reason for the increased worry about a financial crisis is the shock of the October 1987 stock market crash. Unlike many previous dramatic declines in stock prices, the drop of 23% in one day (or 33% compared to the peak two months earlier) led to neither a financial crisis nor a business recession. But the crash vividly demonstrated that the vulnerability of values already experienced in recent years in the markets for more specialized assets—for example, farm land, oil reserves, and loans to developing countries—also extended to so general a class of assets as ownership claims on all of American business. Further, the manifest failure of various “portfolio insurance” schemes to serve their intended purpose cured many institutional investors of the illusion that even if a financial crisis did bring a broadly based decline in asset values, their own holdings would somehow be insulated.

These developments notwithstanding, prevailing attitudes toward the possibility of financial crisis are neither unanimous nor unambiguous. The most familiar concern is that some contractionary disturbance to business activity could result in a cumulative inability of debtors to meet their obligations, possibly leading to some form of rupture in the financial system that in turn might further depress the nonfinancial economy. But no one (to my knowledge) has clearly indicated what set of circumstances would lead to such an outcome, much less suggested how probable those circumstances now are. In addition, there are some arguments for discounting the importance of the changes that have taken place in this regard in the 1980s. For example, some observers have argued that most of the substitution of debt for equity in recent years has occurred in the context of reorganizations that are likely to promote business efficiency and hence provide the higher earnings with which to service the added debt; also, that these transactions are explicitly designed to minimize conventional bankruptcy problems in the event that the anticipated higher earnings do not materialize. Others have pointed out that even after the refinancings of the 1980s, U.S. corporations on average remain much less highly levered than their counterparts abroad.

Whether or not they are valid under today’s specific circumstances, concerns about the likelihood of a financial crisis do reflect a long history of such events playing a major role in the most visible and memorable business fluctuations. The most severe business downturns that have occurred in the United States—for example, those commonly called “depressions”—have in every case been either preceded or accompanied by a recognizable financial crisis. Moreover, while each financial crisis is idiosyncratic in some respects, according to at least some lines of thinking the role of financial crises in this context is not accidental but fundamental to economic behavior in an investment-oriented private enterprise system. At the same time, there is widespread recognition that the likelihood that such a system will experience a financial crisis under any given set of circumstances also depends on institutional safeguards and other factors subject at least in part to influence by public policy.

The object of this paper is to review some of the major lines of thinking about the likelihood of a financial crisis that have emerged in response to the events of the 1980s. Section 1.1 briefly sets this review in context by referring to the long-standing tradition of emphasis on financial crises and their real economic consequences. Section 1.2 outlines the view that the large-scale substitution of debt for equity by U.S. nonfinancial corporations during the 1980s reduced the economy’s ability to sustain fluctuations in business activity without borrowers’ defaulting on their obligations in unusually great numbers and volume. By contrast, section 1.3 examines several different arguments for rejecting concerns about borrowers’ ability to meet their obligations. Section 1.4 shifts the focus from borrowers to lenders and considers the ability of both commercial banks and thrift institutions to withstand a default experience of major proportion. Section 1.5 summarizes the paper’s principal conclusions.

1.1 Financial Crises in Historical Perspective

Few students of economics or business are not familiar with some of the major episodes in the past that are easily recognizable as financial crises. The bursting of the “tulip mania” in 1636 and of the “South Sea Bubble” in 1720, the East Indian Company crisis in 1772, the collapse of the railway boom in 1846, the failure of Union Generale in 1881 and of Baring Brothers in 1890, the U.S. banking panics of 1873, 1893, and 1907, the failure of the Creditan-stalt in 1931 and the worldwide bank collapse of the next two years, and, of course, Black Thursday in October 1929: all this is standard lore, typically related nowadays with substantial color and even sometimes a hint of nostalgia.¹ In fact, although financial crises as such are more difficult to recognize in more primitive institutional environments, the history of such episodes is substantially more ancient.²

The typical features of these events include, in Minsky’s classic description, “large-scale defaults by both financial and nonfinancial units, as well as sharply falling incomes and prices” (1963, 101). Beyond that, however, it is difficult to generalize. Some financial crises have been the inevitable (at least in retrospect) end product of speculative excesses that carried asset prices to levels far beyond any plausible relationship to the corresponding fundamental values. Others—especially those that have followed the onset of war or other major political events—have themselves presumably resulted from sudden reassessments of fundamental values. Still others have resulted from foolish decisions, or bad luck, at specific financial institutions that were large enough and central enough to impair the system as a whole when they failed to honor their commitments. Yet another entire range of influences, not mutually exclusive with any of the above, has typically arisen from the nonfinancial economy. Incomes can and do decline for reasons other than financial crisis. And when they do, on a sufficient scale, the ensuing defaults have at times led to crises in the financial system.

While events in the nonfinancial economy may or may not be the proximate cause of financial crises, the main reason why financial crises are of such great interest from a public policy perspective is presumably the impact that they in turn exert on nonfinancial economic activity. The idea of influences running in this direction is also well known, even if the substantive nature of the behavioral mechanisms involved is not. Of the six U.S. ...